As it seeped into American homes over the weekend, the news that Fannie Mae and Freddie Mac might be in serious trouble had a dreamlike quality to it. When rumours swirl around Wall Street companies, even those with famous names such as Bear Stearns or Lehman Brothers, for most Americans it might mean a slight hit to their college savings fund or a bit of pain in their retirement equity portfolio. However, when the viability of two institutions that are central to the US housing market is called into doubt, it is potentially a personal and national calamity that threatens to undermine faith in the US economy itself.

That was why the Treasury and the Federal Reserve last night moved to try to fix the problem before markets opened today. The package of measures put together confirmed what until now the Government had been reluctant to acknowledge – that the two companies will be bailed out by the US taxpayer to stop their difficulties from becoming a full-blown systemic crisis.

Freddie and Fannie essentially own or guarantee almost half of America’s $12 trillion mortgage market through their role in buying and guaranteeing loans in the secondary mortgage market. As the value of US housing stock grew at an exponential rate over the past decade, the scale of the importance of these two institutions – chartered by the Government but owned by shareholders – exploded.

Troubles in the US mortgage market were always going to be potentially disastrous for these two and, sure enough, last week the scale of their problems became so large that investors took flight.

Last night the US moved on two fronts. First, the Treasury said it would provide additional liquidity as needed. Unlike other financial institutions, such as Bear Stearns, that have got into trouble in the past year, Freddie and Fannie have not faced liquidity problems. But as their problems proliferate, there is always a danger that they might face funding difficulties; hence the treasury’s expanded credit line.

The central problem, however, is that these two institutions are desperately undercapitalised. Freddie Mac, for example, had about $16 billion in shareholder capital at the end of the last quarter, supporting $2.1 trillion in assets. A real private sector financial institution operating with that kind of gearing would be ordered to find more capital instantly. Of course, the Fannie and Freddie situation is actually worse than that. A highly leveraged bank would at least have a diversified portfolio of assets. These government-sponsored enterprises are 100 per cent invested in the US mortgage market, which has proved in the past year to be the last place in the world you would want your money.

So the second component of the Government rescue scheme that was announced yesterday is more important. It is clear that a Government-led recapitalisation is essential. The Treasury and the Fed stopped short last night of diving in immediately and shoring up Freddie and Fannie with new capital. Instead saying they would do so if it became necessary.

Putting the liabilities formally in the hands of the Government would not be as cataclysmic as has been widely claimed. It is true that the pair hold more than $5 trillion in debt, about the size of the current Federal Government borrowing. But the $5 trillion is a gross figure, not a net one. It is backed by $5 trillion in mortgages – the vast majority of which are being paid on time and are secured by homes worth more than the mortgage held on them. Fannie and Freddie deal only in prime mortgages to high-calibre borrowers – not to the notorious sub-prime mortgage-holders.

Even so, there will still be a sizeable cost, especially if house prices continue to fall and push more borrowers – even the prime ones – into default.

Total losses on Fannie and Freddie’s books could run towards $100 billion. But that is a lot smaller than the $5 trillion that some are fretting about and, although it might cost taxpayers, it should not cause a run on the dollar or a surge in US interest rates.

In the end, the cost of resolving the US housing crisis was always going to fall in disproportionate measure on the US Government. Bailing out Fannie and Freddie may be costly and unpleasant, but it’s better than all the alternatives.

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